RECIPROCAL REINSURANCE TREATIES

BY KARL BORC~

I. Introduction
1.1. In this paper we shall study the situation of two insurance
companies which are negotiating wi*h the view of concluding a ceci-
procal reinsurance treaty. We assume that the two companies are
under no compulsion to reach an agreement. This means that if the
companies conclude a treaty, the t l e a t y must be such that both
companies consider themselves better off than without any treaty.
We futher assume that no third company can break into the nego-
tiations. This means that the two companies either have to come
to terms, or be without any reinsurance.
1.2. H o w the two parties reach an agreement in a situation like
this, is one of the classical problems of theoretical economics.
It is usually referred to as the "Bargaining Problem". The problem
appears very simple, but this is a deception. It has proved extreme-
ly difficult to formulate generally acceptable assumptions which
give the problem a determinate solution. The "Theory of Games",
developed b y von Neumann and Morgenstern (IO), does not give a
determinate solution, but it has greatly increased our understanding
of such problems, and the present paper will draw heavily on that
theory.
1.3. The situation which we propose to study, is very simple, m a y
be too simple to have any bearing on reinsurance negotiations in
real life. If there exists a reinsurance market, which also is a
per/ect market in the sense given to this term in economic theory,
bartering between two companies does not make any sense. They
could both do equally well or better b y dealing in the market at
the market price.
To illustrate the point, let us consider two suburban housewives
who go down-town for shopping. If they both do their shopping
according to a well prepared list at a perfect super market, neither
of them will gain anything b y swopping the goods they have bought,
 RECIPROCAL REINSURANCE TREATIES 171

after they get home to their suburb. However, if the two housewives
go bargain-hunting at a sale, they m a y both gain considerably by a
friendly private barter after their return to peaceful suburban
surroundings.
It seems likely t h a t the reinsurance market is more similar to the
bargain counter than to the well-ordered super market, where every-
thing is available at a fixed price. If this is so, there will be scope
for reciprocal treaties, also between companies which have made
full use of their possibilities of dealing in the market.
1.4. Even if the model we propose to study is too simple to have
any practical value, it m a y still be of interest to analyse it in
some detail. Only if we gain a full understanding of the simplest
possible case, t h a t of the two companies, can we hope to tackle the
more complicated cases with some success.

2. The Model
2.1. We assume that Company I has a portfolio of insurance
contracts such t h a t F 1 (xl) is the probability that the total amount
of claims made under these contracts shall not exceed x 1. We shall
call F~ (x~) the risk distribution of Company I. We assume further
t h a t the company holds funds amounting to S 1 which are available
to pay claims. The two elements F 1 (x~) and $1 determine what we
shall call the risk situation of the company.
The company will be solvent in the ordinary actuarial sense if

Similary we assume that Company II has a risk distribution Fa (x2)

and funds S 2. We assume that the random variables xx and x~ are
statistically independent.
2.2. The companies have no control over the random variables
x 1 and xi. If claims amounting to x 1 and x~ occur, the companies
have to meet these claims. Unless they agree otherwise, Company I
will pay the amount x~ and Company II x2. However, the companies
are completely free to agree on any other way of dividing the total
amount of claims x x + x2 between themselves. The companies can
for instance agree that Company I shah pay an amount y (xv x~) if
claims amounting to x 1 and x 2 occur in the two portfolios. Company
I72 RECIPROCAL REINSURANCE TREATIES

II will then have to pay the remainder, i.e. x 1 + x , - - y (Xl, x2).

Hence any real-valued function y (xv x,) defined for all positive
values of x 1 and x, will represent a possible agreement between the
two companies, i.e. a ieciprocal reinsurance treaty.
2.3. The function y (x1, x,) depends only on the total amounts of
claims x 1 and x,. Hence a function of this kind can only represent
a treaty which is truly collective in the sense t h a t the reinsurer's
liability depends only on the total amount of claims. Whether this
amount has arisen as a result of one big claim or a large number of
small ones, is irrelevant. Many, if not most, of the treaties we
meet in practice are not collective in this sense.
It would not be difficult to generalise our model so that such
non-collective treaties can be included. However, this would ne-
cessitate considering separately each contract in the portfolio
and would certainly lead to very cumbersome formulae. It seems
preferable at the present stage to avoid such arithmetical compli-
cations and confine our study to collective treaties.
2.4. It m a y be desirable to give a few examples which will illus-
trate the kind of treaties which can be represented by a function
y (Xl, x,).
(i) N o Treaty. If the companies do not conclude any agreement,
it is obvious t h a t
y (Xl, x,) = xl
(ii) Stop Loss Cover. It is agreed t h a t if claims against Company
I exceed N, the excess shall be paid by CompanyII. Thistreatygives:
y (xl, x,) = x I + P for x I ~ N
= N + P for N < Xl
where P is the premium Company I pays for the cover.
If we want to take into consideration the possibility that Com-
pany II m a y be unable to meet its commitments, we get a more
complicated function. If other claims against Company II have
priority over claims under the treaty, we obtain:
y ( x 1,x,) = x x + P for x 1 < N for all x,
=N+P for N < x x a n d : x , . < S 2 + P + N - x 1
= xl + x a - - S, for N < Xl and $2 + P + N - - x 1
< x2 < $2 + P
=x t+P for N < x 1 and S , + P < x a
 RECIPROCAL REINSURANCE TREATIES 173
In practice it is not usual to consider the possibility t h a t t h e
reinsurer shall become insolvent, b u t in our artificial t w o - c o m p a n y
world such considerations m a y be i m p o r t a n t . Nevertheless, we will
ignore t h e m in the following.
(iii) Quota S h a r e T r e a t y . C o m p a n y I agrees to cede a q u o t a k of
each risk in its portfolio, against a commission a. This is expressed
by:
y (Xl, X2) = (I - - k ) x 1 + k P 1 - - otkP 1
where P1 is the p r e m i u m of the t o t a l portfolio of C o m p a n y I.
(iv) Quota S h a r e w i t h s l i d i n g scale c o m m i s s i o n .
L e t the commission be:

X1
OtI for ~ < r~
w

Xl
~ for ~ > r~

for r I < - - ~ r~
- - -P1
r 2 -- r 1
Inserting this in the expression in the previous example, we find:
Xl
y (x 1, x,) = (I - - k ) x 1 + (I - - oq)kP1 for ~ < rl

= ( I - - k ) x x + (I - - 0 t , ) k P 1 for ~Xl- > ra

k-1

For r 1 < x.A- < r2 w e have:

- - -P1 - -

~1 (r2-- xl Xl
y (Xl, X2) = (I - - k)• 1 + (I - - - P1 ) + 0t, (PI - - rl) ) k p x
r 2- - r 1

= (I - - k + k X l - ~,) Xl + k p I r,~l--rlat2 kp 1
r2 - - rl r , - - rl
In practice we f r e q u e n t l y find treaties where 0q + r x = ~ + r,.
Golding (8) gives an example where r 1 = 0,46, r 2 : o,65, and
~tx + r I = 0t~ + r~ is a p p r o x i m a t e l y o,975- In this case we will
have
I74 RECIPROCAL REINSURANCE TREATIES

Xl
y (x1, x~) = x:+o,o25 k P 1 for 0,46 < ~ < 0,65

Benktander (2) has with some justification called a treaty of this

kind an "Imperfect Nonsense Treaty", perfection being achieved as
r 1 ~ o and r~--~ oo.
2.5. We now assume that the two companies open negotiations
with the purpose of improving their risk situations. The outcome of
these negotiations will be a reciprocal treaty, which we assume
can be represented by a function y (xv xz). However, the purpose
stated has no meaning, unless the companies have some scale o/
value which will enable them to decide whether one risk situation
is better than another.
It seems almost self-evident t h a t an insurance company must
have such a scale of value in order to be able to decide in a rational
manner whether it shall accept or reject any contract which is
offered. If we assume that this scale is complete, in the sense t h a t
it can be applied in any situation, without ever leading to in-
consistencies and discontinuities, this will have far reaching
implications. The precise formulation of these assumptions and
their consequences have been discussed in some detail in a previous
paper (5) and will not be repeated here.
2.6. If an insurance company states t h a t S is the lowest price at
which it will accept responsibility for a portfolio with risk dis-
tribution F (x), the company must somehow consider that the ad-
vantage of receiving the amount S with certainty just balances the
disadvantage of assuming liability for the claims which m a y occur
in the portfolio. This equivalence between a payment made with
certainty and a payment which is a random variable, is the basis
for all insurance contracts.
Assume now that u (x) is the value or utility the company attaches
to the prospect of receiving an amount x with certainty. From the
assumptions mentioned in the preceeding paragraph it then follows
that the company will attach a utility U (S, F (x)) to a risk situation
with elements S and F (x), where

v (s, F = u (s - - d F (x)
o
This is the far reaching implication referred to. It should be
 RECIPROCAL REINSURANCE TREATIES I75

noted that u (x), and hence U (S, F (x)) are determined only up to a
linear transformation. The function u (x) is usually referred to
as the utility o/ money to the company. This function should be
interpreted as a rule for computing the certain payment which is
equivalent to a risk situation. We will assume that u (x) is a non-
decreasing differentiable function of x.
2.7. The purpose of the negotiation between the companies can
now be stated in a more precise manner. Let u 1 (x) be the utility of
money to Company I. The Company's utility in the initial situation
is then

u1 (o) = f ul (sl - - a (xl)

O

The reinsurance treaty defined by y (x1, xz) will change the com-
pany's utility to"

U~ (y) = r ~ u, ( S i - Y (x~, x,)) d & (xl) d F , (x,)

0 0

(It m a y be more consistent if we write U x (xx) for the utility in

the initial situation, but we shall prefer U1 (o)).
In the negotiations Company I will try to secure agreement on a
function y (x x, xs) which gives U x (y) the highest possible value.
If us (x) is the utility of money to Company II, this company has
an initial utility of

us (o) = us ( s s - d Fs (xs)
O

The treaty defined by y (x1, x2) will change this utility to

U s (y) = ~ ~ u, (Ss - - xx - - xs + y (xv xs)) d F x (x~) d Fs(xs)

0 0

In the negotiations Company I I will try to obtain the greatest

possible value of Us (y). Since u I (x) and us (x) are non-decreasing
functions, it is clear that the two companies are pursuing objectives
which are directly opposed and that they will have to reach a com-
promise. The outcome of the negotiations will be a function y (xv x2)
which is optimal in the sense that both parties consider that it
represents the best treaty t h e y could obtain in the given situation.
176 RECIPROCAL R E I N S U R A N C E T R E A T I E S

3. The Optimal Treaty

3.1. In order to determine the optimal treaty, we must make
some assumptions as to the manner in which the negotiations are
conducted. We assume that the companies act rationally and that
they co-operate. This implies that they will not agree on a function
7 (xl, x,) if there exists another function y (x1, x2) such that
Ul(7)--< Ui(Y) and U,(7) --< Us(y)
where both equality signs cannot hold simultaneously.
y (Xl, x2) is clearly inferior to y (Xl,X2), since the latter function
gives a higher utility to at least one of the companies. We say that
7 (xl, x2) is dominated b y y (x1, x2). The set of functions y (x D x2)
which are not dominated is referred to as the Pareto optimal set.
It follows from our assumptions of rationality that neither com-
pany will agree to a function y (Xl, xz) if it gives a lower utility than
the company has in the initial situation. The company will be
better off by refusing to conclude a treaty.
From our assumptions it follows that the optimal treaty is re-
presented b y a function y(xl, x,) with the following properties:
(i) It belongs to the Pareto optimal set.
(ii) It satisfies the conditions:
U1 (o) < U1 (Y) and U 2 (o) ~ U2 (y)
3.2. These conditions will in general define a set of functions,
and not a unique optimal function. To get a determinate solution
to our problem we must make additional assumptions. This can be
done in several ways. The most general and most attractive is
probably the set of axioms proposed by Nash (9).
The basic assumptions made b y Nash is that in a completely
symmetric situation two rational bargainers will agree to maximise
the joint gain, and then divide it equally between themselves.
Applied to our particular case, this means that the two companies
wiU agree upon the function y (x1, x,) which maximises the product:
{ (y (xl, -- Vl (o)) ( us (y (Xl, x,)) -- us (o) }
This function will be referred to as the Nash solution to our problem.
3.3. We will now determine the Pareto optimal set. We assume
that y (x1, x,)belongs to this set, and we consider the function:
 RECIPROCAL REINSURANCE TREATIES 177

7 (Xl, xs) = y (Xl, xs) + * (xl, xs)

where , (x1, xs) is an arbitrary function of small absolute value.
The assumptions t h a t y (x1, xs) is Pareto optimal implies t h a t the
two inequalities
A U i = Ui (7) - - Ui (y) > o
u s = u s (7) - - u s (y) > o
cannot hold simultaneously for a n y , (xl, xo).
We have for Company I

v l = f [ { ul ( s l - y - - , ) - ul ( s l - - y) ) a F~ (x~) a Fs(xs)
o0

Since ¢ (x l, xs) is small in absolute value, we can write

hence

o o

For Company II we find

a V s = f [ u ~ (Ss - - x, - - xs + y) ~ (xl, xs) dF1 (x~) d F s (xs)

oo

Both A U x and A Us will change sign with , (xx, xs). Hence to

make certain t h a t the inequalities
AU~ > o and A U s > o
are not both satiesfied for a n y , (xl, xo) we must require that
A U 1 A U s _ < o for all ¢(xvxs).
A sufficient condition is that
~ (ss - - ~ - - ~s + y) = k ~ ( s l - - y)
where k is a positive constant.
If this condition is satisfied we have

a U~ a Us = - - k { J' [u~ ( S 1 - - y) ~ (x~, xs) d F 1 (x~) d Fs (x~) }s

o o

3.4. To prove that the condition also is necessary, we put

~ ( s s - - x ~ - - x s + y) -- k (ul (S~--y) + ~ (x~, xs) )
where v (xi, x 2 ) = o except over a set A.
178 RECIPROCAL REINSURANCE TREATIES

We can then show t h a t unless

J"d F x (xl) d Fz (x2) = o
A

it will be possible to find a f u n c t i o n , (xx, x~) such t h a t

A U 1 A U~ > o. This proves the statement.
3.5. We have thus found t h a t the Pareto optimal set consists of
the functions y (x~, xz) which satisfy the condition
. : ( s , - - x, - - x, + y) = k u: (s~ - - y)

We have previously assumed t h a t u 1 (x) a n d u z (x) are non-

decxeasing functions. If further we assume t h a t u: (x) and u: (x)
are monotonic decreasing functions (decreasing marginal u t i l i t y of
money), there will correspond at most one function y (x D x2) to a n y
value of k. Hence the purpose of the negotiations between the
companies is to agree on one value of k. It is easy to see t h a t y
will increase with k. Hence the smaller k is, the more favourable
will the t r e a t y be to C o m p a n y I. C o m p a n y II on the other h a n d will
t r y to obtain agreement on the largest possible value of k.
We note t h a t y does not depend on x~ and x 2 separately, but only
on their sum x x + x 2 = z, so t h a t the t r e a t y can be defined by a
function y (z, k).
The Nash solution to our problem will then be the value of k which
maximises

{ u, (y (z, k) ) . u, (o)} { us (y (,, k) ) - - Us (o) }

3.b. It is remarkable t h a t y (z, k) depends only on the u t i l i t y
functions u 1 (x) and u 2 (x) a n d not on the risk distributions F 1 (x)
and F2 (x). This means t h a t the t y p e of reinsurance t r e a t y which
is optimal to two companies, depends only on the objectives which
the companies pursue, or if one prefers another formulation, on the
a t t i t u d e to risk which determines these objectives. The composition
of the portfolios, as expressed b y the risk distributions, enters into
the play only when it comes to selecting a particular value of k.
3.7. The preceeding paragraphs should make it clear t h a t a prere-
quisite to a rational t h e o r y of reinsurance is an operational s t a t e m e n t
of the objectives which the companies pursue. B y " o p e r a t i o n a l "
is m e a n t t h a t the objectives are reduced to t h a t of maximising a
mathematical expression.
 RECIPROCAL REINSURANCE TREATIES I79

Very little is known about these objectives. The few "statements

of policy" which one finds from time to time are usually too in-
complete to make an operational formulation possible. In some
cases one m a y suspect that a statement of objectives, if completed,
would prove inconsistent. It does therefore not seem to be a very
promising approach to collect statements of policy and try to de-
rive from them the properties of the functions which insurance
companies try to maximise in their dealings on the reinsurance
market.
Another approach would be from the normative point of view.
From some general considerations one could probably lay down a set
of rules as to what objectives an insurance company ought to pursue
in its reinsurance policy. From these rules one could then derive
the characteristics of the function which the company should seek
to maximise.
However, before taking up any of these lines of thought, it is
useful to gain some knowledge about the nature of the relations
between the utility function and the optimal treaty. We will
therefore in the following section study a few particular cases.
We will select some mathematically simple and economically accept-
able functions to represent the utility of money and find the
form of treaty which in each case is optimal.

4. Some Special Cases

4.1. The simplest possible case appears to be that of both com-
panies having a linear utility of money, so we are led to consider:

Example I
u l(x) = a l x + b 1 and u l(x) = a ~ x + b2
It is easy to see that in this case the sole objective of the com-
panies is to maximise expected profits. This means that the com-
panies will not take into consideration the possibility of losses
which m a y occur owing to deviations from the expected value of the
amount of claims. It is intuitively clear that in this case there
is no reason for an exchange of risks between the two companies.
This is also brought out b y the condition found in para 3.5
180 RECIPROCAL REINSURANCE TREATIES

u~ (s2 - - z + y / : k ~,~ (sl - - y/

which in this case is reduced to
a2 : alk

Since the utility function is d e t e r m i n e d only up to a linear trans-

formation, the coefficients al and a 2 have no significance, so t h a t
the condition can d e t e r m i n e neither a value k, nor a function
y (xl, x~).
4.2. As the first non-trivial case we will consider:
Example 2
u l (x) : --x~ + ax
u~ (x) : x

The utility function u I ( x ) : - - x 2 + a x has been studied in some

detail in a previous paper (5). It has an acceptable shape for
x < ½a. F o r x > ½a utility will decrease with increasing x, and
this seems unreasonable. If no claims occur, the c o m p a n y ' s funds
$1 will become a clear profit. The utility function ought to be
such t h a t this result appears as the best possible outcome of the
c o m p a n y ' s underwriting, i.e. we should have 2 S 1 < a.
T o rule out a n y distortions due to decreasing utility of m o n e y ;
we will assume t h a t 2 (S 1 + S~) < a.
It is clear t h a t the greater a is, the greater is the weight the
c o m p a n y attaches to expected profits as c o m p a r e d to the weight
given to possible losses.
The function y (z, k) is d e t e r m i n e d b y the relation

I
In this example it is convenient to write ~ in stead of k, so t h a t
the relation becomes:
k :--2(S l-y) +a
which gives
y (z, k) : S ~ - ~ ( a - k)
We see t h a t y (z, k), i.e. the a m o u n t which C o m p a n y I shall pay,
does not depend on x x and ~2. Hence the optimal t r e a t y is t h a t
Company II shall take over liability for the whole portfolio of
Company I, against a compensation of S 1 - - 4 (a - - k).
 RECIPROCAL REINSURANCE TREATIES I81

It is not difficult to see that this must be the outcome of the

negotiations between the two companies. In this example Company
II is not worried about risk of loss. It will accept any insurance
contract as long as the premium it receives is just greater than
the expected amount of claims. However, in its negotiations with
Company I, Company II obviously tries to obtain a compensation
greater than this minimum premium. Company I on the other hand
has a certain risk aversion. This means that it is willing to part with
its whole portfolio, if it can retain a sufficiently large part of its
funds. It will therefore try to pass on its total liability to Company
II, against the lowest possible payment.
4.3. Since this example is very simple, it is useful to analyse
it in some further detail. This will illustrate a number of points
which it will be difficult to bring out clearly in the more compli-
cated examples which will be considered later.
For the initial utilities we have:
Company I

u , (o) = .~ { - - (s~ - - ~)o + ~ (s~ - - ~) } a F (~)

o

Or

UI(o) =--(S I-PI)2Wa(Sx-PI)-VI

where P, = } x d F I (x) - - the mean of the risk distribution - - can
o
be interpreted as the net premium of the company's portfolio, and
where

V , = S ( x - - P 1 ) 2 dF l(x)
o

is the variance of the risk distribution.

Company II
U, (o) = I (S, - - x)* d F, (x) = S, - - P ,
o
After the conclusion of the treaty, the utilities will be:
Company I
u , (y) = - - (½ (a - - k) )~ + ,~ (½ (a - - k) )
or

u ~ (y) = t (a* - - k,)

182 RECIPROCAL REINSURANCE TREATIES

Company II
Us(y) = S i + S 2 - - ( P i + P s ) - - ½ ( a - - k )
It is easily verified that
u~ (y) > u~ (o) for k < V (a - - 2 (s~ - - P~) )s + 4 v l
and
Us (y) > Us (o) for k > a - 2 ( S 1 - P~)
Hence both companies will increase their utility if they agree on
a value of k which satisfies the condition
a-- 2 (S 1 - - e l ) ( k • ~/(a-- 2 (S l - e l ) )s + 4 e l
4.4. From our general assumptions of rationality and co-
operation we can only deduce t h a t the companies will agree on
some value of k in this interval. In order to determine which value
t h e y will agree upon, we must, as mentioned in para 3.2 introduce
some additional assumptions.
According to the assumptions made by Nash, the companies will
agree on the value of k which maximises the product:
{ U 1 (y) - - U 1 (o)} { U 2 (y) - - U 2 (o)}
which in this particular case becomes:
{S x - P ~ - ½ ( a - k ) } { ¼ ( a * - - k s) + (S~--P1) S - -
- - a (S 1 - P1) + Vl}
This value is found to be:
_ I
k = 2 l/(a __ 2 (Sx - - Px) )3 + 4 V1 + ~ (a - - 2 (S~ - - P~) )
3
which is the Nash solution to the problem.
We note t h a t as V~ increases, k will increase, and hence the treaty
will become more and more favourable to Company II. This illus-
trates one of the essential points in a bargaining situation. The
greater Vx is, the more anxious will Company I be to obtain some
reinsurance cover. Company II, knowing this, will take advantage
of the situation and exact a higher price.
It is also easy to show t h a t the amount which Company I pays,
i.e. S x - - ½ (a - - k) will decrease with increasing a, if k is determined
as the Nash solution. This means t h a t the less Company I is con-
 RECIPROCAL REINSURANCE TREATIES 18 3

cerned over the possibilities of loss, the better is the bargain

it can make with Company II.
4.5. Example 3

u~ (x) = - - x ~ + a~ x
The function y (z, k) is determined by
--2(S2--z+y)+a~=k(--2(S 1-y)+ax)
which gives
I k I a 2 -- ark
y(z,k)---- z+ S~ Ss+
I+k I+k I+k 2(I+k)
By some rearrangement this can be written:
I k I
y (x~, x~) - i + k (x~ + xs) + ~ PI i + k P2 +
2 (Sx - - P1) - - 2k ( S s - - P~) + as - - ax k
+
2(i +k)
It is easy to see that in this case the optimal treaty is an exchange
o/ quota shares.
k
Company I cedes a quota ~ of its premium to Company
II. If a claim x~ occurs in the portfolio of Company I, this company
k I
will pay only the retained quota I - - - -I=+ k
i+k
I
Similarly Company II cedes a quota ~ of its premium Pa,
I
and Company I pays the amount ~ x2 if a claim amounting
to x s occurs in the portfolio of Company II.
It is worth noting that the quotas ceded add up to unity.

4.6. Example 4
ul (x) = xt
us (x) = - - x s + ax
The function u x (x) = xt appears fairly acceptable as the utility
function of an insurance company. For large positive values of
I8 4 RECIPROCAL REINSURANCE TREATIES

x the function increases very slowly, and this seems quite plau-
sible for a c o m p a n y which is not primarily concerned with m a k i n g
large profits. The rapid fall in utility as x decreases towards and
through zero also seems acceptable. The function's behaviour
for large negative values of x is not so satisfactory, although
it m a y be possible to provide some justification.
The function y (z, k) is determined by:
k
-- 2 (s, -- z + y) + a = - ($1 -- y)-~-
3
This is an equation of the 5th degree in y. To discuss its roots,
we solve with respect to z and find:
k
z = y--~a + S~ + ~ (s~ -- y)i

F r o m this expression we see t h a t :

(i) As y increases from - - ~ to S 1, z will increase from - - oo to
+oo.
(ii) As y increases from S x to + ~ , z will decrease irom + oo to
a certain minimum, and then increase to + ~ .
Hence to a given value of z there m a y correspond three values oi
y. However, two of these values will be greater t h a n $1, and this
obviously has no meaning, y (z, k) > S 1 for all z and k means t h a t
C o m p a n y I accepts ruin in advance b y agreeing to p a y out more t h a n
the total of its funds, regardless of what the claims m a y a m o u n t
to. However, there exists, for a n y positive z a unique function
y (z, k) < S x which represents the Pareto optimal treaties.
It is clear t h a t this set of treaties will give C o m p a n y I an as-
surance against ruin, since regardless of what the claims are,
C o m p a n y I will never be called upon to p a y more t h a n $1. The op-
timal t r e a t y is thus very similar to a familiar Stop Loss cover.

4.7. Example 5
u~ (x) = log x
u~ (x) = - - x ~ + a x

log x is the utility function first proposed by Daniel Bernoulli.

The function is not particularly suitable for our purpose, so we
will s t u d y it owing to its historical interest, and also because
 RECIPROCAL REINSURANCE TREATIES 18 5

it m a y be useful as a limiting case of more acceptable functions.

The function y (z, k) is given by
k
2(S2--z+y) + a - - Si--y
from which we obtain

y _~ i (a + 2 S 1 -
-- 2S~ + 2z ± l/(a 2 S 1 - 2S~ + 2z)~ + 8k
4
If we take the square root with positive sign, we get
y(z,k) > ½ a - - S z for all k
This means that we for all z and k will have $1 < y (z, k), since
we have assumed in para 4.2 that 2 (S 1 + S~) < a. Hence we dis-
card this case as meaningless, as we did it in the preceeding example.
Taking the negative sign of the square root, we get as the unique
solution a function
y (z, k) < S 1 for all z and k.
Hence the optimal treaty is also in this case a kind of Stop Loss
cover.
4.8. It is interesting to compare the two last examples. It is
clear that Company I is in a much stronger bargaining position
in Example 4 than in Example 5. In the former example the com-
pany is able to face the disagreeable prospect of ruin with some
equanimity. It should therefore be able to make a favourable deal
with Company II.
In Example 5 the company considers its risk situation as infinitely
bad if there is a probability of ruin different from zero, and the
company is willing to pay any finite amount to get out of this
situation. One is tempted to say t h a t a company with this atti-
tude to risk has nothing to do in the insurance business. Company
II will obviously take advantage of this situation and drive a hard
bargain. Since the initial utility of Company I is - - oo, the case
is messy and difficult to analyse in a neat manner, for instance
we can not apply Nash's methods without modifications. However,
it is easy to see t h a t almost any reasonable assumptions will lead
to a treaty whereby Company II takes over the whole portfolio and
all the funds of Company I.
186 RECIPROCAL REINSURANCE TREATIES

4.9. It is also interesting to compare Example 2 and Example 5,

since in both cases the optimal solution was that Company I should
hand its whole portfolio over to Company II. However, in Example
2 Company I did not feel compelled to get rid of its portfolio.
On the contrary it m a y be more to the point to say that Company I
takes advantage of the lighthearted attitude to risk of Company II,
and gets rid of its liability on favourable terms. Company I may
for instance be able to keep as profits a part of the safety loading
in the premium it charged on its direct underwriting.
4.10. All the examples discussed above have given optimal
treaties which in important aspects differ from the reinsurance
arrangements we know from practice. However, these treaties are
optimal only in our two-company model, and only under the as-
sumptions which we have made. Before even thinking of applying
our results in practice, we must examine the model critically. This
is done in the following section.

5. Limitations of the Model

5.1. The most obvious limitation is that our model only deals
with the negotiations between two companies. This point has
already been discussed in para 1. 3. It is well known from the
theory of games that the situation will change radically if a third
company enters into the negotiations. This is brought out clearly
in Example 5. Here Company I considers itself in desperate need
of reinsurance, and Company II takes advantage of this to ac-
quire all the funds of Company I. If, however, a Company I I I
should make a competing offer, which would enable Company I
to retain a part of its funds, this offer will obviously be preferred
to the harsh terms dictated by Company II. This m a y again
induce Company II to make a better offer. If there is no "collu-
sion" between Companies II and III, the problem will have a solu-
tion. In general the solution will be a treaty such that any treaty
more favourable to Company I would give at least one of the
Companies II and I I I a lower utility than they have in the initial
solution.
However, if Companies II and III should agree to join in exerci-
sing pressure on Company I, this company would have to part with
 RECIPROCAL R E I N S U R A N C E T R E A T I E S 187

all its funds. The two other companies would then have to bar-
gain on how they should divide between themselves the proceeds of
their collusion.
Neither the theory of games, nor other theories of oligopoly are
at the present time able to deal with the problem of collusion in
a fully satisfactory manner. It therefore seems extremely diffi-
cult to extend the model to include more than two companies, ex-
cept in the case of perfect competition, or no collusion. This prob-
lem will be the subject of a forthcoming paper (6).
5.2. As mentioned in para 2.4 our model does not take into con-
sideration the possibility that the reinsurer may be ruined. In
Examples 4 and 5 in Section 4 we found optimal treaties which im-
plied that Company I should pay more than its total funds to Com-
p a n y II. These treaties appeared as optimal because they would
be extremely favourable to Company II if they could be carried
out. In the two examples mentioned we were able to reject these
treaties. However, the same factor has obviously had some influ-
ence also in the other examples and m a y have distorted the re-
sults.
We do not propose to study this difficulty any further, since it
is almost entirely of our own making. It has been brought into
the model by our drastic simplifications, and is likely to disappear
in a more general and a more realistic model.
5.3. The model we have studied appears to be completely static.
The risk distribution F (x) was presented as the probability that
the portfolio in hand on a certain day should lead to an amount
of claims not exceeding x by the time when all contracts in the
portfolio have expired. If one can assume that new business comes
in at a rate which will keep the company's risk distribution fairly
constant over a certain period of time, the model may have some
practical applicability, although certainly of a very limited scope.
However, there should be no principal difficulty involved in re-
placing the risk distribution F (x) by a stochastic process F (x, t)
and develop a more general theory. This would leave a major part
of our formulae virtually unchanged, whilst the text would have
to be reworded, and considerably more care would be required in
the mathematical proofs. We have not attempted such a generali-
sation in the present paper, since this inevitably would have
I88 RECIPROCAL REINSURANCE TREATIES

focussed attention on purely mathematical problems, which really

are of secondary importance. The essential elements are the com-
panies' evaluation of risk situations, and the ways in which com-
panies can improve their risk situation through reinsurance arrange-
ments, and these elements can best be understood by a detailed
analysis of a simple and manageable model.

5.4. Our model assumes that both risk distributions are given,
or rather that both companies consider them as given. Behind this
there must be some assumption that the two companies agree on the
evaluation of every probability which enters into either portfolio.
It was this assumption which in para 3.5 led to optimal treaties
implying that the companies should pool their portfolios, and
then seek an agreement as to how the total amount of claims
occuring in the joint portfolio should be divided between the
companies.
If now one company proposes to put into the pool a contract
according to which a claim x may occur with a probability p, the
other company m a y suspect that the probability is underestimated.
This company can either refuse to let the contract enter the pool, or
it can demand that the first company as a proof of good faith shall
retain a part of this contract on its own account, and only let
the remainder go into the pool. We shall not elaborate this point.
It is evident that considerations such as those above will lead
to treaties of a more familiar kind, based on reinsurance of ex-
cedents.
5.5. The assumptions, referred to in para 2.6, which make it
possible to represent a scale of values for risk situations by a real
valued utility function, are usually referred to as the Bernouillian
hypothesis. The hypothesis has been severely criticised by some
authors such as Allais (I). However, most authors seem to accept
it as a normative rule for decision making under uncertainty. It
has been shown by Chipman (7) that under weaker assumptions
utility can be represented by a vector in a "lexicographical"
ordering. We will not here explore the possibilities offered by
Chipman's approach, although his utility concept seems very
suitable for analysing some statements of objectives made by
insurance companies.
 RECIPROCAL REINSURANCE TREATIES 189

5.6. In our model the only purpose of reinsurance is to improve

the risk situation of the company. In practice there are number
of other factors which must be taken into account. For instance
to a small company the contact with a large reinsurance company
m a y be very valuable in itself. The reinsurer will be able to provide
the company with useful advice and information from his world-
wide connections and experience. On the other hand, a recipro-
cal treaty m a y have some inherent disadvantages to two companies
which compete against each other, since the treaty necessitates
making available a considerable amount of information to the com-
petitor.
These factors are closely related to what authors on the theory
of games refer to as "the pleasure derived from the game" and
"the cost of playing the game". They are usually dismissed as
being only of secondary importance, and do not seem to have been
studied very much. We will not at the present study these factors,
although they m a y justify some reinsurance treaties which appear
irrational according to a simplified theory.

6. Conclusion
6.1. The concept of utility has played a rather obscure part in
economics and statistics since it was first introduced by Daniel
Bernoulli (3) more than 220 years ago. The concept enjoyed a
comparatively brief period of respectability when the Austrian
School made marginal utility the very corner stone of economic
theory. The recent popularity of utility is due to von Neumann
and Morgenstern (Io) who made measurable utility an essential part
of their "Theorie of Games". Owing to the vast range of problems
to which this theory can be applied, utility has become an ap-
parently indispensable element in rational decision making,
scientific management and other disciplines closely related to the
problems of reinsurance.

6.2. Nolfi seems to have been the first to apply the modern
utility concept to problems in insurance mathematics. In his
first application (H) he studies the utility function of an insured
person. In a later papei (i2) he studies the utility function which
190 RECIPROCAL REINSURANCE TREATIES

an insurance c o m p a n y should maximise when deciding w h a t

s a f e t y loading to include in its premiums. This function weighs
the loss which m a y occur if the loading is too small, against the
possible inconveniences of a too h e a v y loading. This l a t t e r pro-
blem has also been discussed b y Bierlein (4).
6.3. T h e utility functions used b y these a u t h o r s seem plausible,
a n d lead to reasonable results. One could, however, t h i n k of
o t h e r functions which seem equally acceptable, b u t which will lead
to v e r y different, although still reasonable results.
T h e same applies to the utility functions studied in the present
paper. F e w of the functions discussed in the examples are so
o b v i o u s l y unreasonable t h a t t h e y can be rejected outright. How-
ever, the various functions lead to v e r y different optimal treaties.
W e h a v e no means of saying which of these solutions are right or
wrong, in general, or for p a r t i c u l a r t y p e s of insurance companies.
6.4. The inescapable conclusion seems to be t h a t we know far
too little a b o u t the objectives which insurance companies pursue, or
o u g h t to pursue in their reinsurance policy. However, unless
these objectives can be spelt out in an operational manner, it is
difficult to d e n y t h a t the whole t h e o r y of risk and reinsurance
hangs in the air. It is also difficult to see how one can avoid some
concept of utility in order to build a firm f o u n d a t i o n under this
theory.
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Risque: Critique des Postulats et Axiomes de l'Ecole Americaine",
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(2) BENKTANDER, G. : Contribution to the discussion. Transactions o[ the
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(3) BERNOULLI, D.: "Specimen Theoriae Novae de Mensura Sortis",
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 SICKNESS AND ACCIDENT STATISTICS I91

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